Greenspan Confirms the Fed's Highly Leveraged Fix

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market"(Aucontrarian.com, 2009)

On January 7, 2011, Kelly Evans of the Wall Street Journal interviewed former Federal Reserve Chairman Alan Greenspan. He rooted for the stock market.

Greenspan's circular logic was unenlightening: "Stocks are cheap if earnings are to continue higher." Taken as a whole, this does not mean much, akin to prophesizing: "The Red Sox will win if they score more runs than the Tigers." Greenspan's successful impoverishment of the American people often hinged on the suppression of his dependent clauses: "Stocks are cheap," was all we needed to know.

Greenspan also revealed the (purported) economic recovery is hostage to a bigger and better stock market bubble. He did not put it that way. Interviewer Evans pestered the deaccessioned relic into a defense of the current Fed's market-rigging policy. The former central banker denied any such collusion, but did claim: "The stock market overall is the only type of stimulus that you can get into the economy that doesn't have any debt associated with it." There may never have been greater debt associated with the stock market than in 2011. That, after all, is how it stays up.

Gluskin, Sheff economist David Rosenberg celebrated the new year by publishing some unnerving charts. Margin debt at U.S. broker/dealers has risen 24% over the past year. The hand wringing about atrophied bank lending is a narrow view. A broader investigation shows that commercial banks' trading assets surged $64 billion in December, 2010. UBS Prime Brokerage Services reported on January 12, 2011, that hedge funds have increased their leverage to within 10% of the peak in 2008. Since the bottom (when Lehman Brothers surrendered), gross leverage at hedge funds is up 43%.

A favorite destination for releveraging is stock mutual funds and ETFs - they received $24 billion in net flows in December, 2010. This does not even account for the far greater leverage during buying sprees of S&P 500 futures contracts, the domain of the banks and hedge funds. The institutions have plenty at stake. They took the Fed at its word. ("[H]igher stock prices will boost consumer wealth and help increase confidence..." - Fed Chairman Ben S. Bernanke, November 4, 2010)

The Fed is doing its best to fulfill institutional confidence with its current money-pumping program (QE2). The bulge-bracket brokers compensate for Federal Reserve lapses by raising S&P 500 futures prices when the market flags.

It is this symbiotic relationship that lies beneath Greenspan's confident stock market forecast, an inevitable conclusion after listening to his other reasons to buy stocks, all of which are often associated with an impending crash:

GREENSPAN: "We've had an extraordinary rise in profit margins. This is coming to an end." That may seem to contradict the rationale for his "stocks are cheap" analysis, and it does. Greenspan was never a model of cogency.

The following exchange was of the same quality:

GREENSPAN: "[W]e are going on the assumption that long-term interest rates will stay down. We don't know that...We are in the position we were in 1979....There were no inflation fears, then, within three to four months, we went up 400 basis points [i.e., 4 percent].

EVANS: "Do you think something like that could happen again?"

GREENSPAN: "I think it's a danger."

Inflation had been 12% in 1974 and 9% in 1978, so the leap to 13% inflation in 1979 was not difficult to imagine, except, apparently, to the man who had led the President's Counsel of Economic Advisers from September, 1974 to January, 1977.

My own view is in accord with Greenspan's. Interest rates could very well jump 4%, but, this time it could take 15 seconds. The government-sanctioned machinery that now operates the stock, bond, commodity, futures, foreign exchange, and executive-pay markets is even more susceptible to a miscue than was true when the Greenspan Put assured investors the Nasdaq would never fall below 5,000. (That great unwinding receives its due in Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession.) Should interest rates revert to a proper level, it may take an additional 15 seconds for the stock market to follow.

It is no wonder that after the interview, Business Insider choose as its headline: "Alan Greenspan Sees a Huge Chance of a Bond Collapse, While Lashing Out at His Critics." As to the second half of Business Insider's headline, the incoherent scolding of his critics was pathetic. The less said about it the better.

Liquidate the Fed

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market"(Aucontrarian.com, 2009)

“I would also like to note that the same research paper [produced by the Federal Reserve staff] analyzed the macroeconomic effects of the FOMC's full program of securities purchases [“Quantitative Easing,” usually called, by non-economists, “printing money”], including the first round of purchases that was initiated in late 2008 and early 2009, the modification of the reinvestment policy that was announced last August, and the second round of purchases that was initiated in November. Those simulation results indicate that by 2012, the full program of securities purchases will have raised private payroll employment by about 3 million jobs. Moreover, the simulations suggest that inflation is currently a percentage point higher than would have been the case if the FOMC had never initiated a securities purchases, implying that, in the absence of such purchases, the economy would now be close to deflation.”

-Federal Reserve Vice-Chair Janet L. Yellen; Denver, Colorado; January 8, 2011

“This is a great job, if you like to travel around the country and read speeches written by the staff”

-Federal Reserve Governor Janet L. Yellen, 1997

“Recent data show consumer price inflation continuing to trend downward. For the 12 months ending in November, prices for personal consumption expenditures rose 1.0 percent, and inflation excluding the relatively volatile food and energy components--which tends to be a better gauge of underlying inflation trends--was only 0.8 percent…”

“[I]nflation is likely to be subdued for some time…”

“Very low rates of inflation raise several concerns: First, very low inflation increases the risk that new adverse shocks could push the economy into deflation, that is, a situation involving ongoing declines in prices. [Sic]”

-Chairman Ben S. Bernanke, Testimony before the Committee on the Budget, U.S. Senate, Washington, D.C., January 7, 2011

“From the moment that art ceases to be the nourishment of the best brains, the artist can use all the tricks of the intellectual charlatan. The refined people, the rich ones and the professional layabouts, only want what is sensational or scandalous in modern art. And since the days of cubism I have fed these boys what they wanted and pacified the critics with all the idiotic ideas that went through my head. Whilst I amused myself with all these pranks, I became famous and very rich. I am just a public clown, a fairground barker.”

-Pablo Picasso, 1951, attributed. I doubt he said this; but the description fits academic economists, who, unlike the time at which Picasso (may have) spoken, are of another generation, a generation of professional layabouts that is no longer in on the joke. The clowns and barkers spout idiotic ideas because they only think idiotic ideas.

Illinois is No Peter Pan

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market"(Aucontrarian.com, 2009)

"I'll never grow up, never grow up, never grow up, Not me!"

-Peter Pan, Lyrics from play

"I knew Peter Pan and you're no Peter Pan."

-Vice-Presidential candidate Lloyd Bentsen, (sort of), 1988

"Top Illinois Democrats have agreed to push a plan that would temporarily boost income taxes by 75 percent and double cigarette taxes," harked CBS Chicago on January 6, 2011. The proposed plan would increase Illinois' personal income tax rate from 3 percent to 5.75 percent for the next three years. After that, it would drop back to 3.25%. So they say.

Illinois is a state in which the legislators have so betrayed the taxpayers that a lifetime on Devil's Island would be too good for them. For instance, the liability of the four state pension plans is calculated at $151 billion or $280 billion, depending on the assumptions used. The $280 billion figure is analytically controversial but deductively compelling given the efforts to deny and confuse bondholders and the public alike respecting the coming collapse of the municipal bond market.

Springfield, the capital of Illinois, is a nice town. As state capitals go, it is strikingly uninhabited with a population of 110,000 (and falling, but not as fast as its benefit obligations are rising). Farm country starts about three blocks from the state house. Illinois has more representation in its capital than any other state.

The politicians raised pension benefits faster than poker bids in Macau. Presumably, they have boosted their own benefits faster the state's public servants, who, once they retire, no longer pay one cent for health insurance.

Clay ducks would have done better at funding promises than the elected representatives. There are $70 billion of assets to support the $280 of pension obligations (See The Liabilities and Risks of State-Sponsored Pension Plans, in which Professors Novy-Marx and Rauh lay forth their provocative and engaging argument).

Illinois borrows from the bond market each year to pay benefits, a total of $16 billion since 2007. Bondholders have been paid $550 million (on the first $10 billion) for funding this pyramid scheme. In other words: Illinois taxpayers have paid a $550 million late-fee that, if there were justice in this world, would be paid by the Illinois legislators.

These legislators - and this is true across the country, not just Illinois - cannot conceive of a time when there will be no buyers of bonds to pay benefits that the politicians failed to fund. By borrowing to meet current payments, the "top Illinois Democrats" have fostered the national charade of limitless taxing authority. State General Obligation (G.O.) bonds are backed by the "full faith and credit" phrase, stamped on their offerings. Wall Street research would have it that a G.O. bondholder can take that phrase to the bank. It is from this precipice that bondholders hang by their fingernails.

Goldman Sachs research chips in: "[G]eneral obligation debt is backed by a state or local government's pledge to raise taxes to service that debt if necessary." Barclay's wrote to its California-averse clients that the state is obligated "in good faith to use its taxing power as may be required for the full and prompt payment of debt service."

There are four problems here.

First, the State of Illinois had accumulated over $5 billion of unpaid bills by the end of 2010. Electricity to the governor's mansion will be cut off if the politicians don't grow up.


Second, the authority to raise taxes to meet bond payments often does not work. The most recent instance is the State of Oregon. In early 2010, voters increased tax rates on high earners and businesses to fill a $700 million deficit. Civil servants danced in the streets: "We're absolutely ecstatic," said Hanna Vandering, a physical education teacher from Beaverton and vice president of the statewide teachers union. "What Oregonians said today is they believe in public education and vital services." (The Oregonian, January 26, 2010) On December 16, 2010, the state of Oregon had received one-third less than was expected from windfall tax receipts. Those Oregonians who weren't talking while Hanna Vandering was spouting decided they would rather leave town than contribute to this scandalous love-in between legislators and public unions.

Third, the authority and inclination of courts to issue a writ of mandamus (ordering state officials to raise taxes) is not a topic discussed in brokerage firm research. It is hereby suggested to municipal bondholders who are recipients of such reports to ask why this is so. There have been many decisions in which the court concluded it did not have the authority (or inclination: because efforts, such as in Oregon, are generally unsuccessful) to demand tax increases. The decisions are too varied to discuss here. (See, as a start, Tax Increases in Municipal Bankruptcies, Kevin A. Kordana, Virginia Law Review, volume 83, No. 6, pp. 1035-1107.) Readers may recall that states cannot file for bankruptcy. This is true, but an insolvent body that reneges on its obligations to bondholders will sit in the dock. Municipal decisions are the obvious precedents for the courts.

Fourth, a Sword of Damocles hovers over all transactions and contracts in the United States today: who still trusts the "full faith" of any government body? And, this is the worst situation of all: politicians who think they can fly.

Markets Vanish - "In a Flash"

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market"(Aucontrarian.com, 2009)

Following is a short excerpt from "War of the Nerds," which I wrote for the December, 2006, edition of the Gloom, Boom & Doom Report. I discussed the crises an investor ("Our Serious Investor") navigated from the 1960s to the present. Doomsday had been predicted since the dollar crises of the 1960s, yet risk had been transient. By the fall of 2006, it was obvious the U.S. mortgage market and banking system were in collapse, but securities markets were deemed riskless, as measured by bond and credit-default spreads. It is timely to resurrect the vanishing bond markets of 1914 and 2007 after the failed or distressed auctions since December 27, 2010, of euro zone, Chinese, and U.S Treasury bonds with 5-year and 7-year maturities.

The historian Niall Ferguson (The Cash Nexus, War of the World) has written a paper on the risk imbedded in sovereign bond spreads between 1848 and 1914: "Political Risk and the International Bond Market Between the 1848 Revolution and the Outbreak of the First World War." Published in the Economic History Review earlier this year, his exhaustive study of weekly great-power bond prices (United Kingdom, France, Germany, Austria-Hungary and Russia) comes to a surprising conclusion - the closer Europe edged towards war, the less the financial markets cared. Ferguson sees two distinct periods: from 1848 through 1880, the markets were anxious. Sovereign bonds were sold at the slightest scent of war. After 1880, the response to international tensions grew less and less pronounced.

....It is 2006. Our Serious Investor has grown calloused to once-in-the-history-of-the-universe events. Our Investor survived the dollar crises, the stock market collapse and deep recession of 1973-1974, the Business Week "Death of Equities" front cover, the $250 billion federal budget deficits of the 1980s, the frequent financial and derivative crises of the past twenty years (far more prevalent than between 1950 and 1970), the current $500 billion federal budget deficits, and the (prospective) $1 trillion trade deficit. Our Serious Investor has prospered. He gradually learned to shrug off the deteriorating macro world. He grew accustomed to the "Greenspan put" (that is, central banks will bail out any-and-all financial meltdowns), the risky adventures of hedge funds, the abandonment of debt covenants by bond issuers, the private-equity moon shot; he has, by now, grown so accustomed to the warnings that he keeps his head down, plugs away....

Ferguson's narrative of the countdown to war is a splendid chronology of how quickly the world can change: "It was not until 22 July [1914] - more than three weeks [after Archduke Franz Ferdinand of Austria was assassinated, on June 28, 1914] - that the possibility of a European political crisis was first mentioned as a potential source of financial instability in the financial pages of The [London] Times....

The 2-1/2% British consols rose from a 3.30% yield on July 7 to 3.31% on July 22 - a single basis point of fear.... Tensions rose on the exchanges and grew acute on July 27 when the Vienna and Budapest exchanges closed. The Sarajevo incident could still be interpreted as a local affair, but trading slowed on the other European exchanges. Now [British] consols rose to 3.45%. The St. Petersburg exchange closed on July 29 and the Economist considered the "Berlin and Paris bourses closed in all but name."

....A wholly unanticipated domino effect now engulfed London. The bond market did not seem to acknowledge this vaporization of liquidity: "....The Economist was especially struck by the widening of the bid-ask spread for consols (the gap between buyers' offers and sellers' asking prices) to a full percentage point, compared with a historic average of one-eighth of 1 per cent... "

The London market started to close on July 29. London clearing banks concentrated on funding their stock-exchange clients, eight of which failed by the end of the day. On July 30, the Bank of England raised its discount rate from 3% to 5%. On July 31, the Stock Exchange was closed and the Bank of England raised its discount rate from 5% to 8%.

As to how much we can trust the Greenspan "put": "[T]he British and Continental financial authorities pulled every trick." [Ferguson] furnishes a list of clever, arbitrary and confiscatory maneuvers, but, "systematic central bank interventions to maintain bond prices" only worked for a time. Government assistance "could only disguise the crisis that had been unleashed in the bond market; it could not prevent it." [My bold- FJS]

Ferguson scrapes up the debris: "For all save the holders of British consols, who could reasonably hope that their government would restore the value of their investments when the war was over, these outcomes [for French, German, Austrian, and Russian sovereign bond holders] were even worse than the most pessimistic pre-war commentators had foreseen. The fact that investors do not seem to have considered such a scenario until the last week of July 1914 surely tells us something important about the origins of the First World War. It seems as if, in the words of The Economist, the City only saw 'the meaning of war' on July 31-'in a flash'."

Aside from the origins of World War I, the last week of July 1914 surely tells us something important about investors today.


"The sense of security more frequently springs from habit than from conviction, and for this reason it often subsists after such a change in the conditions as might have been expected to suggest alarm. The lapse of time during which a given event has not happened, is, in this logic of habit, constantly alleged as a reason why the event should never happen, even when the lapse of time is precisely the added condition which makes the event imminent."

-George Eliot, Silas Marner

A Vote for Gold

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market"(Aucontrarian.com, 2009)

"...Bank of Canada Governor Mark Carney tried to calm everyone's nerves by declaring that gold 'has no role to play in the international monetary system.'"

Globe and Mail, November 12, 2010

Carney did not calm the nerves of Hans Merkelbach, investor, advisor, investor advocate, and watch dog of money manipulators, who wrote to the central banker from his office on Bowen Island, British Columbia. After quoting the above, Merkelbach rebuked Carney:

"Let's get real! Would you explain to me why you, the ex-Goldman Sachs partner, besides having a warped idea of monetary matters, made such a ridiculous statement? The houses of cards are falling all around you, dear sir, but I guess it is hard to notice the bloody monetary mess from the ivory tower."

Carney, no fool, but offensively patronizing, replied: "I said in a recent speech...that it is the adjustment mechanism rather than the choice of reserve asset that ultimately matters."

And so he did; the link to his speech follows: http://www.bankofcanada.ca/en/speeches/2010/sp100910.html. Carney is correct. The adjustment mechanism is the topic, not a gold standard, per se. However, the speech makes clear the one adjustment mechanism he will not tolerate is gold.

Carney never addressed the gold standard other to declare it is a "barbarous relic" (Keynes' hackneyed description). The central banker went on to say (in his speech) that instability has followed "the breakdown of Bretton Woods." This is a reference to the 1944 "gold-exchange standard" agreement in which gold was the adjustment mechanism. Under its provisions, foreign governments could convert (pay) $35 to the U.S. government in exchange for one ounce of gold. The United States defaulted on its Bretton Woods commitment in 1971. Afterwards (quoting Carney), "capital flows exploded, rising three times faster than the rate of growth of trade over the past three decades."

That sentence is a tidy summation of why the world's financial system is destined to collapse. No longer constrained by the checks-and-balances of the gold-exchange standard, finance blossomed and grew so large that it is too-big-to-fail: until it collapses. There is no escape.

No company has profited more from this bonanza than Carney's former employer, Goldman, Sachs & Co. There were approximately 1,000 employees at the investment bank in 1971. Today, there are 35,400. They are well paid.

Carney acknowledged that the current "international monetary system is... increasingly unstable." In fact, there is no "system" to speak of other than a gaggle of central bankers, finance ministers and heads-of-state who are constantly issuing contradictory and deceitful statements.

Carney's solution is to beef up the G-20. The latter is a splendidly incoherent group of 20 countries still rehashing the senile economics that inflated Goldman, Sachs. Carney rooted for the "successful completion of G-20 reforms." A more accurate prediction was made by Financial Times columnist Gideon Rachman, who, attending the first G-20 conference last year, wrote: "Watching an Indonesian delegate wandering, apparently carefree, through the conference centre in Pittsburgh, I felt a stab of pity. 'You don't know what you are getting into,' I thought. 'You are going to waste the rest of your life talking about fish quotas.'"

Carney made no comment about the article Merkelbach attached to his letter, "Ben Bernanke: The Chauncey Gardner of Central Banking." The sentry on Bowen Island wrote a preface: "The following article displays the ignorance, stupidity and lies from your Professor partner in Washington."

A gold bar is no more intelligent than Bernanke, but it tells no lies. It should be apparent by now that George Bernard Shaw was right: "You have a choice between the natural stability of gold and the honesty and intelligence of the members of government. And with all due respect to those gentlemen, I advise you, as long as the capitalist system lasts, vote for gold."

Who am I? What is Money? The Fed is Here to Help.

Frederick J. Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market"(Aucontrarian.com, 2009)

"I am a macroeconomist rather than an historian. My focus will be on broad economic issues rather than details."

Professor Ben S. Bernanke, "The Macroeconomics of the Great Depression: A Comparative Approach,"1995

"These days central banking is my line of work as well. Before that, I was an academic economist and economic historian."

Federal Reserve Chairman Ben S. Bernanke, "Economic Policy: Lessons from
History,"April 8, 2008

60 MINUTES: "You've been printing money?"

BERNANKE: "Well, effectively, and we need to do that."

"60 Minutes" interview, March 15, 2009

CONGRESSMAN JEB HENSARLING, (R-TX.) "Will the Federal Reserve monetize the debt?"

CHAIRMAN BERNANKE: "The Federal Reserve will not monetize the debt...."

Federal Reserve Chairman Ben S. Bernanke, Testifying before Congress on June
3,2009

BERNANKE: "One myth that's out there is that what we're doing is printing money. We're not printing money."

"60 Minutes," December 5, 2010

"New research shows that one of the first signs of impending dementia is an inability to understand money and credit, contracts and agreements."

New York Times, "Money Woes Can Be an Early Clue to Alzheimer's," October 31, 2010

"It would be fair to say that monetary and credit aggregates have not played a central role in the formulation of U.S. monetary policy since [1982], although policymakers continue to use monetary data as a source of information about the state of the economy."

Federal Reserve Chairman Ben Bernanke, Open Opportunity Economic Forum,Washington, D.C., November 1, 2006

Response to Federal Reserve Chairman Ben Bernanke:

"...Is it really possible for a policy described as 'monetary' to be formulated and implemented without money playing a central role in it? Indeed, the suggestion that monetary policy can be conducted without assigning a prominent role to money seems like an oxymoron - a statement containing apparently contradictory terms, if not worse: for the literal meaning of the Greek word 'oxymoron' is 'pointedly foolish.'"

Lucas Papademos, Vice President of the European Central Bank, Open Opportunity Economic Forum, Washington, D.C., November 1, 2006

"I don't fully understand movements in the gold price."

"Bernanke Puzzled by Gold Rally" Wall Street Journal blog, June 9, 2010

"[The rising gold price is] strictly a monetary phenomenon...an indication of a very early stage of an endeavor to move away from paper currencies.... What is fascinating is the extent to which gold still holds reign over the financial system as the ultimate source of payment."

Former Federal Reserve Chairman Alan Greenspan, Bloomberg, September 9, 2009

BERNANKE: "Well, this fear of inflation, I think is way overstated."

"60 Minutes," December 5, 2010

"The risk that the economy has entered a substantial downturn appears to have diminished over the past month or so."

Federal Reserve Chairman Ben S. Bernanke, Bloomberg, June 9, 2008

"We do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system."

Federal Reserve Chairman Ben S. Bernanke, speech at the Federal Reserve Bank of Chicago, May 17, 2007

"[T]he recent capital inflow [has shown up in] higher home prices. Higher home prices in turn have encouraged households to increase their consumption. Of course, increased rates of homeownership and household consumption are both good things."

Federal Reserve Governor Ben S. Bernanke, speech before the Virginia Association of Economics, March 10, 2005

"Today, most measures of underlying inflation are running somewhat below 2 percent, or a bit lower than the rate most Fed policymakers see as being most consistent with healthy economic growth in the long run."

Federal Reserve Chairman Ben S. Bernanke, Washington Post, November 4, 2010

60 MINUTES: "Is keeping inflation in check less of a priority for the Federal Reserve now?"

BERNANKE: "No, absolutely not. What we're trying to do is achieve a balance. We've been very, very clear that we will not allow inflation to rise above two percent or less."

"60 Minutes," December 5, 2010

"The unwarranted assumption that 'creeping' inflation is inevitable deserves comment. This term has been used by various writers to mean a gradual rise in prices which, they suggest, could be held to a moderate rate, averaging perhaps 2 percent a year....Such a prospect would work incalculable hardship....Even if it were possible to control it so that prices rose no more than 2 percent a year - the price level would double every 35 years and the value of the dollar would be cut each generation. Losses would thus be inflicted upon millions of people, pensioners, Government employees, all who have fixed incomes, including those who have their assets in savings and long-term bonds...."

Former Federal Reserve Chairman William McChesney Martin, Senate testimony, 1957

"If a policy of active or permissive inflation is to be a fact, then we can rescue the shreds of our self-respect only by announcing the policy. That is the least of the canons of decency that should prevail. We should have the decency to say to the money saver, 'Hold still, Little Fish! All we intend to do is gut you.' "

Malcolm Bryan, President of Atlanta Federal Reserve Bank, 1956

EXPLANATION OF THE FEDERAL RESERVE'S "QUANTITAVE EASING" OBJECTIVE:


"[T]here is a...prosaic way of obtaining negative interest rates: through inflation. Suppose that, looking ahead the government commits itself to producing significant inflation. In this case, while nominal interest rates could remain at zero, real interest rates - interest rates measured in purchasing power - could become negative.... Ben S. Bernanke, Fed chairman, is the perfect person to make the commitment to higher inflation.... [T]he goal could be to produce enough inflation to ensure that the real interest rate is significantly negative...."

Professor Greg Mankiw, "It May be Time for the Fed to Go Negative," Wall Street Journal, April 19, 2009

Mankiw is just the man to recommend such policies:

"[W]hen you look at the mistakes of the 1920s and 1930s, they were clearly amateurish. It is hard to imagine that happening again - we understand the business cycle much better."

Professor Greg Mankiw, Wall Street Journal, February 1, 2000

"If it were possible to take interest rates into negative territory I would be voting for that."

Federal Reserve Governor Janet Yellen, speech at the University of San Diego, then-President of San Francisco Federal Reserve Bank, February 22, 2010

60 MINUTES: "Do you anticipate a scenario in which you would commit to more than $600 billion?"

BERNANKE: "Oh, it's certainly possible"

"60 Minutes," December 5, 2010

Note: $600 billion is the amount of money Bernanke has stated he will to print to buy Treasury securities during "QE2" - Quantitative Easing, Part 2.

The Fed "could theoretically buy anything to pump money into the system" including "state and local debt, real estate and gold mines - any asset."

Unnamed Federal Reserve official to the Financial Times, 2002

"Hello, young man. I'm with the Federal Reserve. Today, we're buying baseball cards."

Cartoon in Grant's Interest Rate Observer, 2010;
Federal Reserve official is speaking to a boy at his front door.

"The truth is the current Fed governors, together with their crack staff of Ph.D. economists and market analysts, are as close to an economic dream team, as we are ever likely to see.... The best Congress can do now is to let the Bernanke bunch do its job."

Professor Greg Mankiw, Harvard University, New York Times, December 23, 2007. Mankiw was chairman of President George W. Bush's Counsel of Economic Advisers

60 MINUTES: "Can you act quickly enough to prevent inflation from getting out of control?"

BERNANKE: "We could raise interest rates in 15 minutes if we have to. So, there really is no problem with raising rates, tightening monetary policy, slowing the economy, reducing inflation, at the appropriate time. Now, that time is not now."

"60 Minutes," December 5, 2010

"There is no validity whatever in the idea that any inflation, once accepted, can be confined to moderate proportions."

Former Federal Reserve Chairman William McChesney Martin, Senate testimony, 1957

60 MINUTES: "You have what degree of confidence in your ability to control this?"

BERNANKE: "One hundred percent."

"60 Minutes," December 5, 2010

"Mr. Bernanke has used the analogy of a golfer with a new putter: Unsure how it will work, he finds the best strategy is to tap lightly at first and keep tapping until the golfer figures out how best to use the putter. [Quoting Bernanke]: 'When policymakers are unsure of the impact that their policy actions will have on the economy, it may be appropriate for them to adjust policy more cautiously and in smaller steps than they would if they had precise knowledge of the effects of their actions.'"

Wall Street Journal, October 27, 2010

"We have been living in a fool's paradise.... [If] the central bank creates money or if you like the phrase better, prints money, I think it can only do one thing, depreciate the currency."

Former Federal Reserve Chairman William McChesney Martin, before the American Association of Newspaper Editors, 1968

"We are in the wildest inflation since the Civil War."

Former Federal Reserve Chairman William McChesney Martin, from his farewell speech, 1970

"Inflation is a means by which the strong can more effectively exploit the weak. The strategically positioned and well-organized can gain at the expense of the unorganized and aged."

Federal Reserve Governor Henry C. Wallich, Commencement address at Fordham University, 1978

Note: Wallich was born in Germany in 1914. He was nine years old, living in Berlin,during the 1923 German inflation.

"[T]he increasing uncertainty in providing privately for the future pushes people who are seeking security toward the government."

Federal Reserve Governor Henry C. Wallich, same address, 1978

"[L]ower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment."

Federal Reserve Chairman Ben S. Bernanke, Washington Post, November 4, 2010

Note: Bernanke simply assumed his QE2 operation would drive down interest rates (the bold will). Just the opposite has happened. Federal Reserve Chairman Martin understood the foolhardiness of such a quest when professors prodded him to do the same:

"It has been suggested, from time to time, that the Federal Reserve System could relieve current pressures in money and capital markets without, at the same time, contributing to inflationary pressures. These suggestions usually involve Federal Reserve support of the Unites States Government securities market through one form or another of pegging operations. There is no way for the Federal Reserve System to peg the price of Government bonds at any given level unless it stands ready to buy all of the bonds offered to it at that price. This process inevitably provides additional funds for the banking system, permits the expansion of loans and investments and a comparable increase in the money supply - a process sometimes referred to as monetization of the public debt. This amount of inflationary force generated by such a policy depends to some extent upon the demand pressures in the market at the time. It would be dangerously inflationary under conditions that prevail today. In the present circumstances the Reserve System could not peg the government securities without, at the same time, igniting explosive inflationary fuel."

Former Federal Reserve Chairman William McChesney Martin, 1957

60 MINUTES: "If you had a message for the American people in this interview what would it be?"

BERNANKE: "...I'd say first of all the Federal Reserve is here and is going to do everything possible to support the economy."

"60 Minutes" March 15, 2009

"Think of all these people, decent, educated, the story of the past laid out before them - What to avoid - what to do, etc.... - trying their utmost - What a ghastly muddle they made of it! Unteachable from infancy to tomb - There is the first and main characteristic of mankind."

Winston S. Churchill, Discussing World War I, 1928

Conclusion: Sell Bernanke and the U.S. dollar; Buy gold and silver.

The Municipal Bond Pitch: "What You're Giving Me is Pure Bulls**t"

Frederick Sheehan is the author of Panderer to Power: The Untold Story of How Alan Greenspan Enriched Wall Street and Left a Legacy of Recession (McGraw-Hill, 2009) and "The Coming Collapse of the Municipal Bond Market" (Aucontrarian.com, 2009)

Undaunted by falling municipal bond prices, rising yields, and withdrawal of funds, research reports by large brokerage firms still mollify the majority of clients and fund managers with numbers and assertions: "General obligation bonds do not default." "The general obligation default rate is 0.01%." "Most states are required by law to balance their budgets." To these and other airtight arguments in the muni marketing kit, the proper articulation of doubt may be expressed as: "Yeah, Yeah, Yeah." Or, one might read "Possible Misunderstandings by Municipalities and Their Bonds."

This précis was written in April 2010. It is a sign of the times that market-making brokerage houses and fund companies still roll out the same phrases and avuncular charm, dismissing critics, but with nothing new to add. Meredith Whitney, an Oppenheimer bank analyst (at the time), told an uncomprehending world in 2007 that banks were going bust. In September 2010, she issued a 600-page report that projected the same for mendicant states and municipalities. One expert replied that he was "somewhat skeptical about Ms. Whitney's sensational hypothesis and [felt] that she might be trying to hit a 'home run' like she did with the banking crisis."

Of course she was trying to hit a homerun! Why else would she write a 600-page report on municipal finance? That has nothing to do with her argument that California, New Jersey, Illinois and Ohio may either default or need a federal bailout in the next twelve months. (Ten months from now, since she stated the warning on September 30, 2010, via Bloomberg TV.)

It has become clear that the states and municipalities facing the greatest financial difficulties will default. This applies to their general obligations and probably many revenue projects, too. This forecast is a synthesis of observation. Those in hock cannot tie their own shoelaces. For investors who hold the municipal bonds of localities where evening news coverage from state houses and town halls could be mistaken for an episode of the Bowery Boys, there is no reason to expose your net worth as an air-raid shelter over the pathologies of American excess.

During the course of nearly two decades setting investment policy and asset allocation with companies, municipalities, and unions, it became clear to me there were organizations (companies, municipalities, and unions) that understood what needed to be done and did it. There were also those that avoided any sort of unpleasantness by delaying, forgetting, or concentrating on minutiae. It was rare for a pension plan's committee to hop from one of these categories to the other. Those that delayed turned manageable situations into quagmires. (A comparison to Washington is apt.)

And so we see, despite the extended period during which municipalities were granted to right their wrongs (the Federal government filled financial gaps), the general tendency among the damned and the dead is, still, to borrow more money. Nearly $42 billion of municipal bonds were issued in November 2010, according to the December 1, 2010; issue of the Bond Buyer. That is nearly one-quarter of the $177 billion municipal volume for all of 2006, a year when property taxes were rising faster than money could be spent, at least among the more sober-minded. The dysfunctional cities and towns managed to build high school gymnasiums that could house the Baths of Caracalla while others started - but never completed - baseball stadiums, renewable energy incinerators, and "tunnels to nowhere." The last is in Pittsburgh, a city apparently yearning for a Municipal Darwin Award. The city counsel is incapable of selling its parking garages for a bid of $423 million, money that is badly needed. The "tunnel to nowhere" is a $500 million public transit project, already $125 million over budget, a clogged artery symbolic of the minds that rule Pittsburgh and those in dozens of cities and states across the United States.

The commonly cited 0.01% default rate applies to general obligation bonds issued since 1970 that were rated by one of the agencies. The 1970s was a decade of great trouble for some municipalities, most of which maneuvered out of harm's way. That was a different time. The level of debt, fixed costs, and corruption; the incapacity to manage, to act, to think logically has blossomed into a New Era. This New Era of concentrated madness, run amok among certain Nasdaq stocks in the late 1990s, was captured by James Burke, a science historian whose study for the Royal Society for the Arts, Opening Minds, was publicized in May of 1999: "Instead of judging people by their ability to memorize, to think sequentially and to write good prose, we might measure intelligence by the ability to pinball around through [sic] knowledge and make imaginative patterns on the web." The weird mutterings of the current Federal Reserve chairman is an example that barely needs mentioning.

Felix Rohatyn, who played the lead role in saving New York City from bankruptcy in the 1970s, spoke recently at a Grant's Interest Rate Observer conference at the Plaza Hotel in New York. His talk was distilled in a subsequent edition of Grant's: "Asked if his experience with New York in the 1970s provided a template for solving the public-debt problems of today, Rohatyn could only lift his palms and shake his head. The numbers are staggering, the constitutional barriers formidable and the political will absent."

The man who accomplished the impossible, the bailout of New York City in the 1970s, is at a loss: "I just don't see where you go to restructure this."

Rohatyn continued: "'I think that if you have to go into some kind of dramatic, last-minute restructuring with these kinds of amounts that we're dealing with, I would just shudder at that.' That the city muddled through in the 1970s Rohatyn attributed to the good-faith efforts of radically different (and usually antagonistic) interests to effect a compromise. In recalling what worked then, Rohatyn found his gravest cause for concern today. Said the long-serving Lazard partner: 'I don't see this anywhere on the horizons today, whether it's at the state or at the level of the city, where I could put together six people, eight people, or 10 people, that you could close the door with and say 'how do we do this?'"

Rohatyn's macro view complements the micro perspective of a veteran who has served on municipal committees and boards for the past forty years. As People magazine might say, what follows is from an exclusive, story-behind-the-story discussion with a man who knows where all the bodies are buried:

No one in the Town is worried about their rating or what others think of the balance sheet. [And, that the municipal bond market might shut down for rollover and new debt- FJS.] There is still a sense that they can pay to have their debt guaranteed and upgraded to save on interest. And rates are so low, what the hell.

All the Towns are in the process of rolling their debt while rates are attractive....The towns are not just rolling debt to lengthen maturities; they are in a sense taking equity out of the house. They are putting a bit of free cash (as it is called on budget) away for future needs, meaning that they are borrowing for next year's budgets. I think we can conclude that there are some new sub prime munis being issued this year. [These are still rated as high-grade bonds by the agencies - FJS]

A town treasurer helped the veteran, who was already well acquainted with municipal finance accounting (and mis-accounting): [He] made sure that I did not stop with the Town's latest "official Statement" dated Sep 1, 2010. "There are certain liabilities which are not on the balance sheet that you should know about. It says our total debt is $98 million, but that does not include our cost of closing the dump ($19 million), our interest due ($9mm), our health insurance liability ($35mm), and the cost of closing the Town's Street and Bridge Lots ($5mm for hazardous waste)." When I asked about the unfunded pension liability, which I know to be in excess of $72mm, he nodded and said something like: "No one is quite sure how to calculate the pension liability, and it is above my pay grade, but it is at least as much as the total Town Debt outstanding; I would use that number."

Felix Rohatyn just published his autobiography, Dealings: A Political and Financial Life. He remembers a meeting in 1975 with the then deputy mayor of New York, James Cavanaugh. The city's finances had so deteriorated that it was not able to issue long-term bonds. (This is a timely reminder of what to expect in 2011: There will be states and cities unable to issue bonds or rollover debt. If the federal government, including the ever-expanding Federal Reserve, does not or cannot fill the gap, scrip will be issued to pay municipal bills and salaries.) Cavanaugh claimed that New York City was running a balanced budget. Rohatyn disagreed. Cavanaugh "breezily" patronized Rohatyn: "I see you don't know much about municipal finance."

The investment banker who had negotiated the largest merger in American corporate history (ITT and Hartford Insurance Company) shot back: "Mr. Cavanaugh, I may not know much about municipal finance. But I know about bulls**t. And what you're giving me is pure bulls**t."

Back to the 40-year veteran. He found the most illuminating document in Massachusetts is the Official Statement (OS). The municipalities are required to publish the OS whenever a new bond is sold to the highest bidder:

The OS is similar to a prospectus, but is far more interesting to read. You need all the schedules so that you can adjust the Town's net worth, so to speak. None of this material is ever put on the web sites of the Town and though there is a law (I am told this) that the Commonwealth [of Massachusetts] should now be posting this information, it was decided by the State House that the cost of this action is not worth the result. They sited [Governor] Deval Patrick's goal of grouping towns as a reason not to put this information on the state's site.

Grouping the financial statements of towns in a consolidated statement, municipalities that already leave over half their liabilities off balance sheet, sounds like a combination of Enron's dirty dealing tucked inside an impenetrable Collateralized Debt Obligation. I may not know much about Massachusetts state house budgeting. But I know about bulls**t. And what the 40-year veteran was told is pure bulls**t."